Transdigm Group Inc. (TDG) has recently hit some turbulence with investment analysts, most notably Wedbush Morgan and RBC Capital Markets. On January 3, 2012, RBC Capital Markets downgraded the company to "Outperform" from "Top Pick," while on January 18 Wedbush Morgan downgraded the company to "Neutral" from "Outperform." These downgrades come on the heels of increased wariness about limited financial upside for Transdigm in 2012, with Wedbush Morgan believing that material upside in commercial aftermarket growth is unlikely in 2012 This has resulted in Webush setting a FY 2012 EPS estimate for Webush Morgan of $5.53, down from Wedbush's previous estimate of $5.63.
However, this fear is largely unwarranted; according to UBS, the commercial aftermarket actually posted the strongest spare pricing since 2007-2008, even factoring in below-normal backlogs and lower airline capacity growth! This promptly led UBS to raise guidance on Transdigm to $110 per stock. This leads to the obvious conundrum: which of these antagonistic opinions is correct? I strongly believe that UBS is spot-on and Transdigm will, contrary to the downgrades initiated by Wedbush Morgan and RBC Markets, prosper in 2012.
Transdigm is a Cleveland-based company operating in the Aerospace/Defense Products & Services industry that designs, produces, and supplies engineered aircraft components for use on commercial and military aircraft principally in the United States. What separates Transdigm from its direct competitors such as Honeywell International Inc. (HON), Goodrich Corp. (GR), and United Technologies Corporation (UTX) is the fact that around three-quarters of Transdigm's sales come from items only Transdigm produces.
For example, for the fiscal year of 2009, Transdigm generated approximately 80% of its net sales from products for which it was the sole source provider, a percentage which has stayed in the same range even into 2012. This allowed Transdigm to rake in enormous profits and develop a basic stranglehold in the sector on specific goods. Moreover, the vast majority (95% in 2009) of Transdigm's net sales is generated by proprietary products for which Transdigm owns the design, which allows Transdigm unprecedented competitiveness and influence in this sector.
Transdigm's advantage is playing out well at a time of major airline refurbishing and expansion. Boeing (BA), one of Transdigm's largest customers, forecasts that Middle East airlines alone will order more than 2,500 new jets worth $450 billion through 2030. With new orders of airplanes comes new airplane components such as lighting systems, engine sensors, and overhead bin latches, which in turn will prove beneficial to Transdigm's bottom line.
However, Transdigm isn't content with the idea of simply resting on its laurels and continuing to generate income off of its competitive advantage; instead, Transdigm has exhibited an aggressive desire for expansion that bodes well for the company's continued profitability in the future. According to AlacraStore, Transdigm has completed 15 acquisitions over its company history, with the most recent one being an $84 million purchase last month of Harco Laboratories. Harco Laboratories makes aircraft engine components and is expected to add ~$40 million in revenue to the bottom line, with acquisitions adding ~$180 million in revenues in 2012. Overall, Transdigm's presence in its industry is expanding and it is poised to continue prospering on a string of acquisitions, significant competitive advantages, and strong demand from airlines.
Transdigm recently reported strong earnings and continues to exhibit strong fundamental performance. In its 2011 4Q, it posted a 42% increase in EPS year-over-year, which is even more significant considering this figure is higher than the average EPS growth of the last 3 quarters, which stands around an already strong 34%. Also, 4Q earnings were 16.9% above analyst estimates, while sales increased 54% year-over-year. Although estimate revisions are down for the current quarter, Transdigm is still expected to post a 47% EPS increase compared to the same quarter of last year.
Transdigm's extremely positive 2011 4Q is not surprising, as Transdigm has consistently posted progressive growth over the years. It has had 4 years of consecutive EPS growth and a solid 16% 3-Year Sales Growth Rate as well as a 13% 3-Year EPS Growth Rate. For 2012, the annual EPS is expected to increase by 25.05% compared to 2011's annual EPS figures.
Transdigm also exhibits strong profitability. Its Annual ROE is 34% while its Annual Pre-Tax Margin is 29.9%, both of which are on the high end of its sector. Moreover, it has a Gross Margin of 57%, more than double the industry average of 25.40%, as well as an Operating Margin of 42.56%, more than 4x the industry average of 10.27%. These strong signs of relative profitability bode well for Transdigm in the future.
It should also be noted that there is a significantly negative aspect to Transdigm's fundamentals: Transdigm has a significant 385% Debt/Equity Ratio. This in turn could put Transdigm at the mercy of creditors, payment deadlines, and interest rates. Transdigm's ability to pay rests largely on its ability to continue generating positive sales and earnings figure. Although it is unlikely Transdigm's debt will have significant adverse effects on the company in the short-term, the long-term effects are much less certain. However, Transdigm has recently shown initiative in cutting down its debt; the Debt/Equity Ratio has been decreasing from a high of 534% in December 31, 2010 to 427% in June 30, 2011 to the current 385%.
It should be noted that despite the RBC Capital Market and Wedbush Morgan's downgrades, of the 17 analysts currently covering the stock, 8 consider it a "Strong Buy" and there are no "Underperform" or "Sell" recommendations. If we take in the aggregate analyst opinion, Transdigm has a 1.9 buy rating, which continues to be around the top of the pack in the industry, beating the ratings of such competitors as Honeywell and Goodrich.
Moreover, in Transdigm's most recently reported quarter, it noted a 3% increase in institutional funds holding stock, which has led to 8 consecutive quarters of increasing fund ownership for this company. Overall, Transdigm is poised to benefit from its unique position in its niche and the overall strength of its fundamentals, factors which could very possibly contribute to a rosy 2012 for its stock price.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TDG over the next 72 hours.